Econ 208 Week 4

• Derived from the IS-LM equilibrium.
• We assume an increase in prices. The supply of real money balances decreases shifting the LM curve to the left leading to a lower level of output. 
• Therefore a higher level of prices leads to a lower level of output
• The AD curve sums up this negative relationship between prices and output. 

The nominal wage, w, depends on three factors:

• Expected price level, 
• Unemployment rate, u
• A variable, z

Firms set their price according to :

    is the mark-up of the price over the cost of production.

• Combine the price setting and wage setting by putting them both equal to w

• Express unemployment rate in terms of output:  

• Therefore for a given labour force, the higher the output, the lower the unemployment. 
• Replace the uneployment rate with the equation in step 1. 

• An increase in output leads to an increase in the price level. (Increase in Y leades = increase in N = decrease in u = increase in w = increase in p) - upward sloping. 
• An increase in the expected price leads to an increase in the actual price (increase in Pe = increase in w = increase in P)
• The AS curve goes through point A where Y=Yn (natural rate of output) and P=Pe. This means when Y>Yn, P>Pe and when Y<Yn, P<Pe.
• An increase in Pe shifts the As curve up and a decrease in Pe shifts the AS curve down.

At point A the labour market and the goods market are all in equilibrium 

• Wage setters will revise upwards their expectations of the future price level. 
• This causes AS to shift upwards
• This leads to a higher nominal wage and a higher price level.
• The adjustment ends once wage setters no longer have reasons to change their expectations.
• In the medium run, output returns to natural rate. 

• In the AD equeation - an increase in M leads to an increase in the real money stock (M/P)
• This leads to an increase in output and the AD curve shifts to the right.
• In the short run the output and price rise.
• The difference between Y* and Yn sets in motion the adjustment of price expectations
• In the medium run, the AS curve shifts left and returns the economy back to Yn.
• The increase in prices is proportional to the increase in the nominal money stock.

A monetary expansion leads to an increase in output on the short run but no effect in the medium run. 

• A decrease in public spending = decrease in output.
• Decrease in output = real money stock rises = LM curve shifts to the right.
• IS curve shifts left to restore equlibirum = both Y and r and lower than before

Deficit reduction in the short tun leads to a decrease in output and interest rates. In the medium run output returns to its natural level while the interest rate keeps falling further.